Loan Loss Provision

What Is a Loan Loss Provision?

A loan loss provision is an income statement expense set aside as an allowance for uncollected loans and loan payments. This provision is used to cover different kinds of loan losses such as non-performing loans, customer bankruptcy, and renegotiated loans that incur lower-than-previously-estimated payments. Loan loss provisions are then added to the loan loss reserves, a balance sheet item that represents the total amount of loan losses subtracted a company's loans.

How a Loan Loss Provision Works

Banking industry lenders generate revenue from the interest and expenses they receive from lending products. Banks lend to a wide range of customers, including consumers, small businesses, and large corporations.

Lending standards and reporting requirements are constantly changing, and constraints have been rigorously tightening since the height of the 2008 financial crisis. Improved regulations for banks resulting from the Dodd-Frank Act focused on increasing the standards for lending, which have required higher credit quality borrowers and also increased the capital liquidity requirements for the bank.

Despite these improvements, banks still have to account for loan defaults and expenses that occur as a result of lending. Loan loss provisions are a standard accounting adjustment made to a bank’s loan loss reserves included in the financial statements of banks. Loan loss provisions are consistently made to incorporate changing projections for losses from the bank’s lending products. While standards for lending have greatly improved, banks still experience late loan payments and loan defaults.

Because the loan loss provision appears on the income statement as an expense, it will lower operating profits.

Loan Loss Reserves in Accounting

Loan loss reserves are typically accounted for on a bank’s balance sheet, which can increase by the amount of the loan loss provision or decrease by the amount of net charge-offs each quarter.

Loan loss provisions are constantly made to update estimates and calculations based on statistics for the bank’s customer defaults. These estimates are calculated based on average historical default rates by different levels of borrowers. Credit losses for late payments and collection expenses are also included in loan loss provision estimates and are calculated using a similar methodology, which takes into account the previous payment statistics of a bank’s credit clients.

Overall, by setting aside loan loss reserves and constantly updating estimates through loan loss provisions, banks can ensure they are presenting an accurate assessment of their overall financial position. This financial position is often released publicly through the bank’s quarterly financial statements.